Invest in Individual Stocks or Mutual Funds?

This is a guest article by Barbara Friedberg, editor-in-chief of Barbara Friedberg Personal Finance. Barbara holds an MBA in finance, a BS in economics, and an MS in counseling. In addition to writing, Barbara is a portfolio manager and a professor.

“The business schools reward difficult complex behavior more than simple behavior, but simple behavior is more effective.” — Warren Buffet

The greatest investor of this generation is espousing a fundamental investing maxim. Keep it simple and you will prosper. In fact, research shows that the more investing trades one makes, the worse their return.

How I went from funds to stocks — and back to funds

I started out terrified of investing in stocks either individually or in funds because of the crash in 1929. I thought that I would lose all my money if I invested in stocks of any form. That was before I had much investing knowledge.

History shows that stocks have outperformed bond and cash investments over the long term. Throughout the twentieth century stocks averaged 9.0%, with plenty of ups and downs along the way. Does that mean they will always perform that well? Absolutely not! In fact, the ten year return of the Vanguard Total Return Stock Index (VTSMX), effective July 27, 2010 is only an annual 0.05%. During that time period, cash and bond investments outperformed stock investments. That’s a far cry from the 9.0% per year average return.

After studying historical returns, I decided to invest in a stock mutual fund through my workplace retirement fund. I had 75% of my contribution allocated to a broad-based stock fund and 25% to a cash investment with a fixed return.

Over time, which do you think performed the best? If you guessed the stock fund, you were correct. But I was still happy to have the fixed return fund since it tempered my portfolio value when the stock market returns moved lower.

Buoyed by the performance of the stock fund and motivated by my passion for investing, I decided to investigate investing in individual stocks. I read every investing resource I could get my hands on and came across a non-profit organization designed to teach a fundamentally based stock research methods, the National Association of Investors Corporation. Their tools enabled me to research and analyze individual companies, look at their financial ratios, compare their valuation metrics and make a reasoned investment decision.

It was so much fun for me: the hours of reading annual reports, comparing return on equity, PE ratios, and more with similar companies. Of course graphing the metrics over time gave me a visual view of the direction of the companies’ sales and earnings.

During this period, I surpassed the benchmark returns by a couple of percentage points. I also earned an MBA in finance and got a job as a portfolio manager.

Investing in individual stocks is a lot of work!

Not only does the investor need to decide when to buy, but she must determine when to sell. That’s two opportunities to make a wrong decision. Furthermore, every investor has losses, and some of them are large. One of my worst stock losses was a decline of over 50%. Fortunately, I had the time and knowledge to devote to investing in individual stocks. I also had a temperament that is suited to remaining calm during the inevitable volatility of the investments.

Over the last few years, I have sold most of my individual stocks opting for a diversified portfolio of index funds.

Why I prefer fund investing to individual stock investing

The efficient market hypothesis supposes that in most cases it is difficult to beat the return of the overall stock market. There are many exceptions, but overall, holding a diversified portfolio of index funds or exchange traded funds is an efficient way to match the historical returns of the stock market. In fact, very few professional mutual fund managers beat the average stock market returns over time!

Advantages of investing in stock mutual funds over individual stocks

Diversification

Low cost

Less research and maintenance time

OUTPERFORM most actively managed funds

Invest in individual stocks if you:

Enjoy the research and analysis necessary to choose individual holdings

Have enough education to read a balance sheet and understand financial ratios

Have sufficient time to devote

Can tolerate the excess volatility above and beyond that of the overall market

Editor’s note: I (Flexo) invest mainly in stock mutual funds such as VTSMX but I occasionally dabble in individual stocks beyond my company stock purchase plan. I’ve lost money doing this — on paper, since I have not locked in any losses by selling. I still believe the companies I’ve invested in are good companies and will eventually see their stocks increase beyond my purchase price, and some have already. Do you invest in individual stocks or mutual funds?

From a money-saving point of view, I noticed that after your mutual fund holdings reach about $120,000, it’s actually cheaper to trade individual stocks than to keep investing in a broad market mutual fund. Just purchase and readjust holdings in about 30 to 40 of the same stocks that are listed on the Dow (or a diversified sample of the S&P500), and you’ll end up with the same portfolio, minus the few hundred a year mutual fund maintenance fees. But I also don’t believe researching individual stock information and metrics is useful.

I don’t know. By my calculation, a diversified portfolio of Vanguard admiral shares would cost less than $100 per year at that level. For the amount of time mutual funds save you, they are an absolute bargain. You certainly couldn’t pay me $500 to manage your portfolio of 40 stocks. Plus, you wouldn’t have adequate diversification with that strategy anyway.

Possibly less than $100, if you stick to the 0.08% ones ($84?). I believe that a portfolio of 30+ stocks is about as diversified as you can get within a market, but the 0.08 Admiral Shares are usually only for US stocks. This way you can buy some large international ones, too. As I said, there’s not much “management” involved. Every paycheck just keep buying the one you’re low on compared to others *shrug*

No self-respecting investor would own ONLY the U.S. market. And buying individuals foreign securities takes a LOT of work because they don’t always file such neat annual reports. You just can’t get decent diversification at a reasonable cost without investing tens of millions of dollars. And even then, why would you bother?

That’s true, so I guess unless I try to follow a foreign index with the same idea (maybe there will be a reliable one by the time I get to $120k :), I’d just use this strategy for the US portfolio portion of my overall investment. Still, even just off the top of my head, I can think of a few international companies that are large, stable, and could add to diversification of my portfolio (I don’t think reading their financials will matter as much as their reputation and number, since I’m a believer in efficient portfolio theory)
Personally, I have about 30% in international index fund (and another 30% in small cap index) so I totally agree with you on diversifying outside of US.

eric ♦1,549 (Half-Dollar)

Definitely the bulk is in mutual funds (index funds to be exact). I have some play money in individual stocks but that’s all it ever will be…play money. :)

@Kyle-To do a competent job of stock investing, I agree that you must devote considerable time to researching, updating, and managing the individual stock portfolio.
@Rassah-Interesting concept, in otherwords, create your own quasi market index. One thing you are forgetting is the time involved in rebalancing that quantity of holdings as well as the risk of not researching any of the holdings. Index ETF’s and mutual funds do all of the rebalancing within the fund for you and with 3-5 different funds, your personal rebalancing each year of so is done in a snap. Consider the value of your time.Your remark highlights how each individual has their own values and parameters for investing.
@ Eric-Sounds like a reasonable strategy.

If you follow Dow or S&P500, the research is done for you. If mutual fund or ETF charged 0.18, that’s $216 per year off $120k in maintenance fees. With Sharebuilder’s $4 per auto investment, that’s about 54 trades, or 4.5 trades per month. If you just keep buying the stocks that are in the Dow, keeping them evenly split, buying only shares that are below the 1/30th amount of your total portfolio, and only once in a while spending $9 to sell stocks that have been dropped from the Dow, I suspect you’ll be able to do about as well as an index fund or ETF. At most the research will be lookin at what’s in the index, and downloading prices into an excel sheet. Probably about 5 to 10 minutes of work. As the portfolio grows, this could translate to increasing savings. Granted the savings may still not be worth the bother.
Personally, I would love to some day try this with Berkshire Hathaway’s BRK.A stock, buying the same stocks/companies he holds in his $120k per share stock. Granted by the time I buy, the price would already have speculatively adjusted to being purchased by Buffet.

I invest in both mutual funds/ETFs and individual stocks. I maintain a diversified portfolio of index funds across all my investment accounts (IRA, 401K, and standard brokerage), but within each, I have significant holdings of stocks. I thoroughly enjoy the research, and am beating all the indexes over 1,3,5 year periods (I only truly started investing about 7 years ago).

@Rassah, Your strategy sounds in line with modern portfolio theory. But don’t forget to add some international stocks for diversification, as other parts of the world are likely to grow faster than the USA. As you mentioned, it is a personal decision whether the addtional time is worth the monetary savings. If you have the time, any savings is money in your pocket (or investment account). Interesting analysis!
@EVan-You are another smart one, low price to book and Low PE stocks have historically outperformed. If history holds, you are on the right track!
@Robert-Seven years is a pretty good length of time to test your theory. As you enjoy the research, sounds like you are doing great. Thanks for sharing!

Another important point regarding international diversification is this; Most large and mega cap US stocks receive up to 50% of their profits from international operations. That said, the smaller and developing markets offer a chance (although not so much recently) at lower correlation with US markets, increasing diverisfication, and opportunity to improve returns and moderate risks.
@Investor, sounds like you are following a proven approach!

I see no reason not to take penny-sized positions. You just have to have the right personality for it. Walk carefully and carry a big stick. :) I was bombarded with the idea that pinks were poison, and that a person should never, under any circumstance, buy such stocks. That idea eroded, and I saw that with careful footing, I could use the leverage (small price and millions of shares) to my advantage. If you believe in the company, holding it is not a problem.

BTW, I understand I cannot suggest a specific site, but I would suggest that you utilize a large bulletin board that is often populated by many people who’ve been around the block a few years. Many have already done DD and it has been posted. That doesn’t mean you have to take it at face value, but if it makes sense, it is usually correct.

@Dragon, Investing in a small niche such as pink slips definitely requires the right personality, as well as high risk tolerance, (willingness to take substantial losses) and ability to perform extensive research. Best of luck to you!

I completely understand where the majority of these comments are coming from, however, stock investing can be done very successfully. I would suggest that a part of the equation of stock investing is missing and that contributes to less success.

I’ve been investing in stocks for 14 years and have learned a thing or two… if one only looks at fundamentals in an attempt to successfully buy and sell stocks it won’t work! I know, I started that way. Because I was so unhappy with the outcome, I continued to read and learn and eventually begin looking at charts. The technicals of a chart can assist in timing – yes, timing for when to get into a position. The saying that “you can’t time the market” is misinformation (amazing how over time that benefits the financial industry and not the individual investor).

This applies to market direction also. Understanding how to read market direction can make a big difference. For example, one should not be taking long positions in a market that is tanking (picture 2008). There were signals before the disastrous end of 2008. Personally, I managed to pull a 3% gain out of that year.

I would contend that adding a technical aspect to investing will dramatically increase stock investing success. Technical indicators like RSI, moving averages, ADX, etc. These things might sound complicated, but basically they are visual tools for price action and easily understandable. These things can indicate the beginning of a trend and using good risk management one can do very well with stock trading.

Hi Stock Trading Warrior, Thanks for such a thoughtful comment. I have to differ with your thesis, empirical research has proven that over the long term, technical analysis is less effective than buying the market (indexing). That said, it does not mean that NO ONE WILL DO WELL with a technical strategy. It means that long term, most technical analysis practitionerss will underperform. I am happy the strategy is working for you and wish you continuing success in your investing endeavors. Thanks for the comment.

For me, the key is that you should invest in something you understand! If you don’t understand it, don’t get into it. At the end of the day, your are your sole master of your finance. Stock investing can be quite good but you need to do the work. I have both stock and mutual funds. Some mutual funds are not by choice as it’s part of a define pension plan. The company contribution is really where my growth is. When it comes to mutual funds, I am quite please with index investing. As for my stock picking, I am a dividend investor looking for compound growth with my dividends. Both are quite boring :)

I like excitement. ;) That said, I am not “willing to take substantial losses.” I realize I may take some losses, and I haven’t had any big ones, yet. Most of the losses I’ve taken were due mostly to reshuffling my portfolio. So far, I’m very optimistic about making money. I’ll be happy to return with a report in a few weeks, or possibly in the first quarter.

@Dragon, As long as you are investing in stocks and bonds for the long term (5+ years) the historical trend has been upward. A tip; keep an eye more on your overall net worth and less on the individual holdings ups and downs.

@ Barb
As I’ve learned recently, a stock can be –very, very stressful–. Seems the parties had a falling out. One party put the company into chapter 7 in order to pressure the other party (the inventor.) The other party finally decided to do business, and things are going forward.

I generally do follow your advice on my stocks, except for this one stock. It has the potential to be a superstar, and actually going to dollars/share.

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About Luke Landes

Luke Landes founded Consumerism Commentary in 2003 and has been building online communities since 1990. Luke has contributed to PC World Magazine, US News, Forbes, and other publications. Read more about Luke and about Consumerism Commentary.

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